Performance audit, Department of Revenue, follow-up report

AUDfWOR GENERAL
REPOR1 SUMMARY
September 1987 Report No. 87- 6
The Office of the Auditor General has conducted a performance audit of the Arizona Department
of Revenue ( DOR) in response to a July 26, 1985, resolution of the Joint Legislative Oversight
Committee. This performance audit was conducted as part of the Sunset Review set forth in
Arizona Revised Statutes 9941- 2351 through 41- 2379.
The purpose of this audit is to perform a follow- up review focusing on two previous performance
audit reports of the Department of Revenue. These reports, issued by the Auditor General in 1985,
are: Report 85- 5, Taxatiorr Division and Hearing Office; and Report 85- 9, Tax Processing
Function. This audit reports the extent of the Department's compliance with the recommendations
contained in the two previously issued reports.
The Department Has Made Some Changes In Audit Operations,
But Additional Efforts Are Needed
The Department of Revenue has not expanded audit coverage as recommended in the 1985
performance audit. Although the report estimated that increasing audit coverage of sales/ use tax
accounts would produce an estimated $ 18 million in additional assessments, coverage remains
un,-? anged, at approximately 1 percent for sales tax. DOR plans to increase audit coverage to 4
percent of the sales tax and corporate income tax account population, but only recently requested
the additional staff needed to increase coverage. DOR did not request additional auditors until
fiscal year 1988, and even though 15 new positions were authorized for fiscal year 1988, DOR
officials do not plan to f i l l them until at least February 1988 when its new building is expected to
be completed. Each month's delay in hiring the new auditors will result in the loss of an estimated
$ 600,000 in potential assessments.
Although some progress has been made, selection systems continue to need improvement and the
cyclical audit schedule of major sales taxpayers is outdated. Our analysis showed that 122 major
taxpayers were not scheduled for audit, while 65 scheduled audits were for taxpayers no longer on
the Department's list of large accounts. DOR staff attribute the discrepancies to changes in the
population of major taxpayers. However, the schedule has not been updated, as required by a
Department policy, since it was first prepared in early 1986. The Department has also been unable
to complete more than one- fifth of its 1985- 86 major taxpayer audits, and has not started or
completed more than 80 percent of its 1986- 87 audits of major taxpayers.
DOR has, however, improved some areas of its audit operations. A review of recent audit files
indicates that DOR has strengthened control of the audit process by improving documentation and
supervision. The Department has also established a training unit to develop a training program and
improve auditor capability to audit large, complex accounts; streamlined the audit protest process;
and eliminated the backlog of pending cases in the Hearing Office.
To improve audit coverage, DOR should continue its efforts to increase sales tax and corporate
audit staff. To resolve existing audit selection systems weaknesses, DOR should frequently review
and update its audit schedule of major sales tax accounts, and should develop an automated audit
history and selection system for corporate income tax accounts similar to that currently being
developed by the Sales Tax Audit unit.
The Department Of Revenue Has Largely Addressed
Recommendations Made To Improve Tax Processing
The Department has improved the effectiveness of its tax processing function by virtually
eliminating its use of long- term temporary workers. DOR accomplished this by converting 24
full- time positions occupied by temporary workers to permanent positions during fiscal years 1987
and 1988. Revenue officials report that the conversion has reduced turnover and increased
productivity as we had predicted.
DOR has also taken steps to reduce taxpayer errors that contribute to processing problems, by
increasing taxpayer education and improving tax form designs. Additionally, the Processing
Section has corrected one major source of DOR caused processing errors by key verifying social
security number entries.
DOR has strengthened its control over outside contractors. The 1985 audit reported that poor
fiscai monitoring aiiowed a data entry vendor and a personnel services vendor to overcharge the
Department by $ 447,500. Both vendors have agreed to repay the overcharges in the form of credits
and discounts. To prevent future overcharges, the Department now monitors billings through a
computer program that verifies data entry keystrokes.
Controls over monies have also improved. A recent audit conducted by the Financial Audit
Division of our office found receipt handling procedures to be adequate. However, the Department
still lacks an independent internal audit group to test adequacy of procedures and compliance with
them. DOR requested funding to create such a unit in fiscal year 1987- 88, but the request was
denied.
DOUGLAS R NORTON. CPA
AUDITOR GENERAL.
STATE OF ARIZONA
OFFICE OF THE
AUDITOR GENERAL
LINDA J. BLESSING, CPA
DEPUTY AUDITOR GENERAL
September 10, 1987
Members of the Arizona Legislature
The Honorable Evan Mecham, Governor
Mr. C. " Has" Hoskins, Director
Department of Revenue
Transmitted herewith is a report of the Auditor General, A Performance Audit
of the Department of Revenue. This report is in response to a July 26, 1985,
resolution of the Joint Legislative Oversight Committee.
The report is a follow up review of the Department's progress in implementing
recommendations made in previous audits of the Department's tax audit function
and its tax processing function. We found substantial improvement in both
areas. The Department has developed badly needed training for its auditors and
has improved audit supervision. However, audit coverage for sales/ use and
corporate income taxes has not changed significantly since our previous audit
and the Department needs to continue to improve its ability to identify and
select the largest, most productive accounts for audit.
In addition, the Department has improved tax processing. Tax forms have been
redesigned to better assist taxpayers in avoiding common errors. Use of
temporary employees to f i l l critical processing positions has been eliminated and
the Department has taken steps to reduce employee errors that contribute to
processing problems.
My staff and I will be pleased to discuss or clarify items in the report.
Respectfully submitted,
~ 0d'gl. hR~. Norton
Auditor General
Staff: William Thomson
Mark Fleming
Cindy Whitaker
Anthony Guarino
Kurt Schulte
2700 NORTH CENTRAL AVE. @ SUITE 700 @ PHOENIX, ARIZONA 85004 @ ( 602) 255- 4385
SUMMARY
The Office of the Auditor General has conducted a performance audit of the
Arizona Department of Revenue ( DO R) in response to a July 26, 1985, resolution of
the Joint Legislative Oversight Committee. This performance audit was conducted
as part of the Sunset Review set forth in Arizona Revised Statutes § § 41- 2351
through 41 - 2379.
The purpose of this audit is to perform a follow- up review focusing on two previous
performance audit reports of the Department of Revenue. These reports, issued by
the Auditor General in 1985, are: Report 85- 5, Taxation Division and Hearing
Office; and Report 85- 9, Tax Processing Function. This audit reports the extent of
the Department's compliance with the recommendations contained in the two
previously issued reports.
The Department Has Made Some Changes In Audit Operations,
But Additional Efforts Are Needed ( see pages 5- 13)
The Department of Revenue has not expanded audit coverage as recommended in
the 1985 performance audit. Although the report estimated that increasing audit
coverage of salesluse tax accounts would produce an estimated $ 18 million in
additional assessments, coverage remains unchanged, at approximately 1 percent for
sales tax. DOR plans to increase audit coverage to 4 percent of the sales tax and
corporate income tax account population, but only recently requested the additional
staff needed to increase coverage. DOR did not request additional auditors until
fiscal year 1988, and even though 15 new positions were authorized for fiscal year
1988, DOR officials do not plan to f i l l them until at least February 1988 when its
new building is expected to be completed. Each month's delay in hiring the new
auditors will result in the loss of an estimated $ 600,000 in potential assessments.
Although some progress has been made, selection systems continue to need
improvement and the cyclical audit schedule of major sales taxpayers is outdated.
Our analysis showed that 122 major taxpayers were not scheduled for audit, while 65
scheduled audits were for taxpayers no longer on the Department's list of large
accounts. DOR staff attribute the discrepancies to changes in the population of
major taxpayers. However, the schedule has not been updated, as required by a
Department policy, since it was first prepared in early 1986. The Department has
also been unable to complete more than one- fifth of its 1985- 86 major taxpayer
audits, and has not started or completed more than 80 percent of its 1986- 87 audits
of major taxpayers.
DOR has, however, improved some areas of its audit operations. A review of recent
audit files indicates that DOR has strengthened control of the audit process by
improving documentation and supervision. The Department has also established a
training unit to develop a training program and improve auditor capability to audit
large, complex accounts; streamlined the audit protest process; and eliminated the
backlog of pending cases in the Hearing Office.
To improve audit coverage, DOR should continue its efforts to increase sales tax
and corporate audit staff. To resolve existing audit selection systems weaknesses,
DOR should frequently review and update its audit schedule of major sales tax
accounts, and should develop an automated audit history and selection system for
corporate income tax accounts similar to that currently being developed by the
Sales Tax Audit unit.
The Department O f Revenue Has Largely Addressed
Recommendations Made To Improve Tax Processing ( see pages 15- 20)
The Department has improved the effectiveness of its tax processing function by
virtually eliminating its use of long- term temporary workers. D 0 R accomplished
this by converting 24 full- time positions occupied by temporary workers to
permanent positions during fiscal years 1987 and 1988. Revenue officials report
that the conversion has reduced turnover and increased productivity as we had
predicted.
DOR has also taken steps to reduce taxpayer errors that contribute to processing
problems, by increasing taxpayer education and improving tax form designs.
Additionally, the Processing Section has corrected one major source of D 0 R caused
processing errors by key verifying social security number entries.
DO R has strengthened its control over outside contractors. The 1985 audit reported
that poor fiscal monitoring allowed a data entry vendor and a personnel services
vendor to overcharge the Department by $ 447,500. Both vendors have agreed to
repay the overcharges in the form of credits and discounts. To prevent future
overcharges, the Department now monitors billings through a computer program
that verifies data entry keystrokes.
Controls over monies have also improved. A recent audit conducted by the
Financial Audit Division of our office found receipt handling procedures to be
adequate. However, the Department still lacks an independent internal audit group
to test adequacy of procedures and compliance with them. DOR requested funding
to create such a unit in fiscal year 1987- 88, but the request was denied.
TABLE OF CONTENTS
Page
INTRODUCTIONANDBACKGROUND. . . . . . . . . . . . . . . . . . . . 1
FINDING I : THE DEPARTMENT HAS MADE SOME CHANGES IN AUDIT
OPERATIONS, BUT ADDITIONAL EFFORTS ARE NEEDED . . . . . . . . . 5
Level Of Audit Coverage I s Low And
Unchanged Since Previous Report . . . . . . . . . . . . . . . . 5
Audit Selection Systems For Both Sales
Tax And Corporate Income Tax Need Further Improvement . . . . . 7
Sales Tax and Corporate Income Tax Audit Units
Have Taken Steps To Improve Audit Q u a l i t y . . . . . . . . . . . 11
DOR Has lmproved I t s A b i l i t y To Process
Protested Assessments . . . . . . . . . . . . . . . . . . . . . 12
Recommendations . . . . . . . . . . . . . . . . . . . . . . . . 13
FINDING II: THE DEPARTMENT OF REVENUE HAS LARGELY
ADDRESSED RECOMMENDATIONS MADE TO IMPROVE TAX
PROCESSING . . . . . . . . . . . . . . . . . . . . . . . . . . 15
DOR No Longer O v e r - u t i l i z e s Temporary Workers . . . . . . . . . 15
The Department Has Taken Action To Reduce
Processing E r r o r s . . . . . . . . . . . . . . . . . . . . . . . 16
DOR Has Upgraded I t s F i s c a l Monitoring
OfOutsideVendor C o n t r a c t s . . . . . . . . . . . . . . . . . . 18
Controls Over Receipts Have lmproved . . . . . . . . . . . . . 19
Recommendations . . . . . . . . . . . . . . . . . . . . . . . . 20
AGENCYRESPONSE . . . . . . . . . . . . . . . . . . . . . . . . . . 21
LIST OF TABLES
TABLE 1 - Audit Coverage Levels For Sales/ Use And
Corporate Income Tax For Fiscal Years
1984- 85 Through 1986- 87 . . . . . . . . . . . . . . . .
Page
. 6
INTRODUCTION AND BACKGROUND
The Office of the Auditor General has conducted a performance audit of the
Arizona Department of Revenue ( DOR). The audit was conducted in response to a
July 26, 1985, resolution of the Joint Legislative Oversight Committee as part of
the Sunset Review set forth in Arizona Revised Statutes § § 41- 2351 through
41 - 2379.
This report is a follow- up review which examines the steps taken by DOR to
implement recommendations made in two previous performance audit reports issued
by the Auditor General in 1985: Report 85- 5, an audit of DO R's tax audit function;
and Report 85- 9, an audit of the Department's tax processing function.
The Tax Audit Function
DORIS Tax Compliance Division, formerly the Taxation Division, contains two Tax
Audit Units: Sales/ Use Tax, and Income Tax. An officp: in Tucson also performs
sales/ use and income tax audits. These units conduct in- house audits of taxpayer
returns and field audits of taxpayer records to determine whether taxpayers are
accurately reporting and paying tax liabilities. Audits generate revenue when they
reveal that additional tax monies are owed to the State. DOR reported total audit
collections of $ 55.6 million in fiscal year 1984- 85, and $ 48.9 million in fiscal year
1985- 86.
However, several deficiencies were noted in a 1985 audit issued by the Auditor
General. It was reported that: 1) Audit coverage was low and DOR could collect up
to $ 18 million annually in additional revenue by increasing its sales tax audit effort;
2) DOR could increase revenue by improving audit selection systems; 3) DOR lacks
adequate controls to ensure the quality and integrity of audit assessments,
modifications and amendments; and 4) Protested assessments are not processed
efficiently, which increases the potential for loss of revenue.
The Tax Processing Function
Tax processing consists of several work procedures, and is performed within DOR's
Data Management Division. Tax returns are received in the Document Staging area,
where individual documents are briefly scanned to determine i f they look
processible. The returns are then sorted by tax type and fowarded to the Document
Processing areas, where they are batched with like documents and prepared for N C R
coding ( ' I or data entry. Once in the Data Entry area, document information is
entered into the computer system. If a tax document contains an error, caused by
either the taxpayer or DOR personnel, the computer rejects the form and the
document is sent to one of the Error Resolution areas for correction.
Our 1985 audit identified several problems with tax processing. The previous report
noted that the Department: 1) was excessively using temporary employees to f i l l
full- time positions; 2) could reduce processing errors and correct errors more
efficiently; 3) needed to improve its contract monitoring procedures; and 4) could
improve its control over receipts.
Scope Of Audit
This audit of the Department of Revenue's tax audit and processing functions is
limited to a follow- up of recommendations made in the two 1985 audits issued by
the Auditor General. It examines steps taken by DOR in the following areas.
0 The level of audit coverage for sales tax
0 Audit selection systems
0 Controls to ensure the quality and integrity of audit assessments, modifications
and amendments
( ' 1 NCR ( National Cash Register) machines are used by DOR to encode and s e r i a l i z e a l l
tax documents with money attached, and a l l checks accompanying these documents. Tax
documents received without money bypass NCR coding.
a The efficiency and timeliness of the protest process
a The utilization of temporary staff for tax processing
a Processing errors
a Contract monitoring
a Receipt handling controls
This audit was conducted in accordance with generally accepted governmental
auditing standards.
The Auditor General and staff express their appreciation to the Director and staff
of the Department of Revenue for their cooperation during the course of the audit.
FINDING I
THE DEPARTMENT HAS MADE SOME CHANGES I N AUDIT
OPERATIONS, BUT ADDITIONAL EFFORTS ARE NEEDED
The Department of Revenue ( DOR) Tax Compliance Division is taking steps to
comply with recommendations made by the Auditor General in 1985, but
improvements to date have been limited. The Department has not increased audit
coverage for sales/ use and corporate income taxes. Selection systems for each tax
type require additional improvement. However, the Department has improved audit
quality through stronger review and control, and has eliminated the Hearing Office's
backlog of protested audit assessments.
Level Of Audit Coverage Is Low,
And Unchanged Since Previous Report
Although DOR has developed a plan to increase audit coverage for both sales and
corporate income tax, current levels remain low. Current coverage is low compared
to DOR's goal of 4 percent for both sales/ use and corporate income tax. The
Department has recently received approval to hire additional auditors; however,
these positions w i l l n o t be f i l l e d immediately and are insufficient to meet coverage
and staffing goals.
Our prior audit report determined that DOR could generate up to $ 18 million in
additional revenue by performing more sales tax audits. To perform these audits, we
recommended that DOR increase its audit staff ( 24 auditors at an annual cost of
approximately $ 1 million). More audit staff would provide for a more favorable tax
base coverage and, therefore, increase audit assessments. We also recommended that
DOR study the feasibility of increasing corporate income tax audit staff.
Low coverage - Audit coverage levels have changed l i t t l e since fiscal year
1984- 85. DOR has adopted our recommendation of a 4 percent target level for both
While s t a f f s i z e has remained s t a t i c , the number o f sales accounts has grown
s i g n i f i c a n t l y . A t t h e t i m e o f o u r p r e v i o u s r e p o r t , there were approximate1 y 95,000
t o t a l sales tax accounts. As o f June 1987, the accounts had increased almost 27
percent t o 120,337.
salesluse tax and corporate income tax audits. However, this goal has not been
attained, and audit coverage for sales tax has, in fact, decreased. ' I' The
following table summarizes approximate audit coverage levels for the last three
fiscal years.
TABLE I
AUDIT COVERAGE LEVELS FOR SALES/ USE AND CORPORATE INCOME TAX
FOR FISCAL YEARS 1984- 85 THROUGH 1986- 87
Sour
Tax Type Fiscal Year
1984- 85 1985- 86 1986- 87
Sa I es/ Use 1 . l% 1.05% 1 . O%
Corporate Income 1.9 2.1 2.1 ' a'
( a ) This figure i s an estimate because complete data was not a v a i l a b l e .
: DOR budget request for f i s c a l year 1987- 88, and Auditor General
analysis based on information provided by the Assistant
Director of the Tax Compliance D i v i s i o n .
DOR management has determined that to reach its audit coverage goals, sizable
increases in audit staff will be necessary. The Department's fiscal year 1987- 88
budget request details a plan calling for 80 additional sales tax positions, based on a
three year phase- in period, while the corporate income tax unit plans to add 10
positions over two years. For fiscal year 1987- 88 DOR requested 36 audit positions
( 30 sales, six corporate). Only 15 ( 11 sales, four corporate) "' were approved. A
concerted effort to gain approval for these positions was not apparent
( ' ) These figures exclude four a u d i t o r positions approved f o r a u d i t selection and audit
review.
until the fiscal year 1987- 88 budget request. D 0 R did not request any audit positions
for fiscal year 1985- 86, in part because the fiscal year 1985- 86 request was prepared
before our report was issued. However, audit positions again were not requested in
fiscal year 1986- 87.
Hiring delayed - Although 15 new audit positions have been approved, the Director
of the Department does not intend to f i l l them until DOR conducts a staffing
analysis, and until the completion of the new DOR building, projected for February
1988. According to the Director, this delay is necessary due to insufficient space in
the existing office. The Department also plans to conduct an internal staffing
analysis to identify whether any existing staff can be transferred to f i l l the sales/ use
and corporate income tax audit positions. Furthermore, Department officials
indicated that before hiring more auditors, they want to complete development of the
Auditor training program and improve audit selection. However, since each auditor
generates approximately $ 40,000 in assessments per month, D 0 R stands to lose more
than $ 600,000 in assessments for each month the newly approved audit positions are
not filled.
Audit Selection Systems For Both Sales Tax
And Corporate lncome Tax Need Further Improvement
The audit selection systems used by the Sales Tax unit and the Corporate lncome Tax
unit still need improvement. Although the Sales Tax audit unit has placed all major
taxpayers that annually remit more that $ 500,000 in taxes on a cyclical audit
schedule, it still lacks a fully developed, automated selection system for the rest of
the population. Furthermore, the Corporate lncome Tax Audit unit has not been able
to place high dollar taxpayers on a cyclical schedule and still relies on a cumbersome
manual system for audit selection. DOR has improved auditor training to strengthen
its ability to conduct complex audits.
Our previous report noted that sales tax is the State's best tax revenue producer, and
that fewer than 2 percent of the sales tax accounts pay 70 percent of the total sales
taxes. A t the time of our last audit, a random sample of 300 of these large accounts
revealed that only 20 percent had been audited between January 1981 and August
1984. Our analysis showed that up to $ 3.6 million could be generated yearly i f DOR
audited more large sales tax accounts. Greater coverage of large corporate income
tax accounts was also recommended.
Sales Tax schedule - DOR acknowledges the need to review major taxpayers, and
has placed the 360 identified sales tax accounts with an annual tax remittance of
more than $ 500,000 on a schedule to ensure that each account is reviewed within the
four year statute of limitations. However, this schedule is not kept current and
timely completion of scheduled audits is not occurring.
Although a cyclical sales tax audit schedule has been developed, i t contains outdated
information. The sales tax audit unit developed its audit schedule for large accounts
using a DOR computer report of sales tax remittance data for several recent years.
To determine whether DOR has accurately identified and scheduled large accounts,
we compared accounts listed on the June 1987 computer report ( which contains
year- to- date remittances) to those accounts scheduled for audit during fiscal years
1988 through 1991. Our analysis revealed 122 of the 360 accounts listed on the report
that were not scheduled for audit, and 65 scheduled accounts that were not on the
report.
Sales tax audit selection staff attribute these discrepancies to changes in the
population of the major taxpayers, and the fact that the four year schedule has not
been updated since i t was first prepared in early 1986. DOR procedures call for an
annual review and update of the four year schedule. However, the procedure does not
indicate when the review should occur. As a result, the first review is tentatively
scheduled in December 1987, nearly two years after the four year schedule was
initially prepared.
In addition to having an outdated schedule, DOR is not able to review the accounts on
the schedule in a timely manner. We reviewed the audit schedules for fiscal years
1985- 86 and 1986- 87 and found that as of June 1987, nearly one- fifth of the audits
scheduled for 1985- 86 had not been completed, and more than 80 percent of the
audits scheduled for 1986- 87 had not been completed or started. This low rate of
completion raises concern, because only 41 audits of 31 accounts were scheduled for
1985- 86. and only 43 audits of 37 accounts were scheduled for 1986- 87.'') Since
DOR has not been able to complete these scheduled audits, problems in completing
the 90 accounts per year scheduled for audit for the next four fiscal years seem
imminent without additional audit staff.
Although DOR has a system to identify and schedule large sales tax accounts for
audit, i t does not have a fully developed selection system for the rest of the sales tax
population. Our previous report recommended that DOR continue work on the
M AASS ( Marginal Analysis Audit Selection System). M AASS, first obtained by DO R
in 1982, is designed to select accounts that have the highest assessment potential
within each industrial classification. DOR management has determined that the
problems encountered with M A ASS cannot be overcome. Consequently, the decision
was made to abandon this system and develop a similar, yet scaled- down model more
suitable for use within the Sales Tax audit unit. However, DOR does not expect this
system to be fully implemented and usable for another two years.
The new system, although not currently equipped for selecting accounts for audit
from the entire sales tax population, does show the progress the unit has made in
improving its audit selection system since our previous audit. The system, a
computerized audit history data base, contains pertinent account information on
audits and reviews completed since January 1983. The unit uses the data base for
scheduling audits and various other analyses. For example, the sales tax audit unit
uses the system to prepare the four year audit schedule of large sales tax accounts to
identify past lucrative audits and schedule follow- up audits of these accounts, and to
perform other evaluations of past audits.
Corporate selection system is still deficient - The corporate income tax audit unit
is not accurately identifying some high dollar accounts for audit, and has not placed
accounts on a cyclical audit schedule. This is due primarily to lack of current,
automated account data, as well as continued reliance on a manual selection process.
The number of scheduled audits i s g r e a t e r than the number of accounts because some
accounts were scheduled f o r both sales tax and use tax audits.
The 1987- 88 budget request states that all large corporate accounts are audited
every three years. Working with corporate audit staff, we attempted to verify this
assertion. A DOR report showing accounts reporting more than $ 500,000 yearly in
taxable income was compared to the unit's audit logbooks. Our analysis revealed that
approximately 53 percent of these large accounts had been audited since 1983.
Further analysis of a different report listing accounts with more than $ 500,000 in
annual tax remittance showed that only 58 percent of these largest taxpayers had
been audited since 1983.
Large accounts have not been identified in a timely manner, partially because the
present selection system is a manual, cumbersome process, which involves the yearly
examination of more than 50,000 returns. This process occupies the entire Phoenix
office corporate income tax audit staff for approximately one month.
Improved training - DOR has improved auditor training in response to a need
recognized in our previous report. Our previous report identified major deficiencies
in the level and amount of training given sales and corporate auditors. At that time,
both the sales tax and corporate income tax units had many auditors who had
received little or no training, and management commented that few staff were
capable of performing large, complex audits.
DOR recognized and took steps to correct this problem. Presently, three full- time
training coordinators are developing such a program to meet auditor training needs.
The training coordinators work with experienced auditors to develop technical
curriculum. DOR estimates show that sales and corporate income tax auditors have
devoted approximately 350 hours on course development from August, 1986 to
August, 1987. Audit staff also contributed 120 hours as instructors during formal
training sessions.
The manager feels that the program is only about one- third of what is needed, and
additional courses are being planned to train auditors in techniques for handling
different types of sales tax and corporate income tax audits. While many of the
courses currently being taught are general in nature, future courses being developed
will have a more technical emphasis. Further, a cooperative training program with
the IRS has been implemented.
Sales Tax And Corporate Income Tax Audit Units
Have Taken Steps To Improve Audit Quality
Our review of recent salesluse and corporate income tax audit files showed evidence
of improved documentation and review. Each unit has developed and formalized i t s
own review procedures. In addition, the Department is in the process of establishing
an independent audit review unit. However, policies for auditor rotation and
reporting of bribery have not yet been developed.
Our previous report identified inadequate controls for ensuring the integrity of audit
decisions and guarding against abuses. Significant changes were made to audit
assessments with l i t t l e or no review or documentation. In one case, this lack of
control resulted in DOR forgoing more than $ 1 million in tax assessments. In another
instance, an auditor was dismissed for failing to report a possible bribery attempt.
We recommended a centralized quality control unit as a means of reducing the
potential for abuse.
Formalized review - Both the SalesIUse Tax and Corporate Income audit units have
developed and implemented audit review procedures. ( " Each unit now requires
supervisory review and sign- off on all assessment documents, as well as separate
verification of all calculations. Our review of a small sample of files showed
adequate review in the sales tax audit files, but corporate income tax files showed
the need for more consistent evidence of review. ( 2 )
Review unit approved - Three of the newly approved audit positions are designated
for a centralized, independent quality control unit for all tax types to conduct an
objective technical review of completed audits and any resulting modifications or
amendments. This review group would help audit managers identify weaknesses in
documentation. Furthermore, the unit should provide better quality and more
consistent review because i t will be independent from the audit units, with review as
its only function.
( ' 1 Although our review was of Phoenix o f f i c e f i l e s o n l y , t h e A u d i t Administrator i n the
Tucson o f f i c e stated t h a t h i s a u d i t s t a f f use s i m i l a r review procedures.
( 2 ) DOR was unable t o l o c a t e one of the 20 sales tax f i l e s we requested f o r our review.
This f i l e contained a s i z a b l e assessment m o d i f i c a t i o n .
No rotation or bribery policies - Tax Compliance Division management has not
established formal policies for rotating auditors or reporting bribery attempts.
Management felt that high turnover in recent years precluded the need for such
policies. However, recent reclassification of the revenue auditor position has
reduced turnover, making rotation a necessity. Regardless, to improve control over
the audit function and prevent potential collusion between auditors and taxpayers,
DOR should adopt policies to l i m i t the number of consecutive audits of the same
taxpayer performed by an auditor and to require the reporting of bribery attempts.
DOR has improved its ability to respond to and process assessments that are
protested by taxpayers. The protest tracking system has been streamlined and
simplified through automation. The Audit Management Information System ( AMIS)
has automated all audit assessment records. The Hearing Office has improved the
timeliness of its process and has eliminated its backlog of cases.
A t the time of our previous report, the protest system relied on excessive manual
processing of documents, which resulted in errors and mishandling of cases. The
inefficiency was demonstrated by the 59 documents, five separate card files, and
eight logbooks used to process and track protests. Also, the Hearing Office had a
backlog of 63 pending cases that had been backlogged an average of 16 months.
AMlS was developed with the initial intention of automating the protest process.
According to Tax Compliance Division management, AMlS has eliminated the
reliance on the numerous and cumbersome card files and log books formerly used to
track protests.
More important, the Hearing Office now issues most decisions within 60 days.
According to the hearing officer, as of May 1987 only one case was pending more
than 60 days.
RECOMMENDATIONS
1. DOR should f i l l the newly approved auditor positions as soon as possible, renting
extra office space i f needed.
2. DOR should continue to request additional audit staff until i t is able to achieve a
coverage level of 4 percent for all salesluse and corporate income tax accounts.
3. DOR should ensure its sales/ use tax major account audit schedule is updated
annually for proper identification of these accounts.
4. DOR should make the resources available for the development of an automated
selection system and audit history database for the corporate income tax audit
unit.
5. DOR should continue to develop technical courses for its auditor training
program.
6. DOR should develop a policy mandating the rotation of auditors and reporting of
attempted bribery.
FINDING II
THE DEPARTMENT OF REVENUE HAS LARGELY
ADDRESSED RECOMMENDATIONS MADE TO
IMPROVE TAX PROCESSING
Although improvement is needed in some areas, the Department of Revenue ( DO R)
has largely addressed recommendations made in a prior performance audit to
improve its tax processing function. The Department no longer relies on temporary
employees, and has taken steps to reduce tax processing errors. DOR has upgraded
its contract monitoring procedures, and has made improvements in its receipt
handling controls.
In September 1985 the Auditor General issued a performance audit report on DOR's
tax processing function ( Report 85- 9). That report contained recom mendations on
the following topics: the use of temporary employees and staff training; tax
processing errors; fiscal monitoring of outside service contracts; and internal
controls over tax revenues. This follow- up review details the actions taken by the
Department to address those concerns raised in our previous report.
DOR No Longer Overutilizes Temporary Workers
DOR has improved its tax processing function by significantly reducing its reliance
on temporary workers. A comprehensive training program for permanent staff,
however, has yet to be developed.
A t the time of the previous audit, DOR used temporary personnel to an extent that
impaired the tax processing function. At least 37 and possibly as many as 60
temporary positions were continuous, year round positions. Temporary personnel
comprised between 40 and 52 percent of DOR's total processing staff. Our audit
work showed that temporary personnel are generally less productive than permanent
workers. As a result, the Department could actually save money by converting
temporary positions to permanent ones. In addition, temporary workers experienced
high turnover ( more than 200 percent annual turnover in some sections) and inhibited
DORIS ability to maintain a trained staff.
Decrease in temporary personnel - DORts reliance on temporary personnel has
significantly decreased since 1985. DOR converted 12 full- time positions occupied
by temporary workers to permanent positions in both fiscal years 1986- 87 and
1987- 88. These 24 positions were funded through transfers from the temporary
personnel services budget. ) Because of these actions, temporary personnel
will no longer be employed on a continuous, year round basis, but rather during peak
processing periods only. Moreover, DOR officials report that the decision to
convert temporary positions to permanent has stabilized staffing, as anticipated,
and resulted in productivity gains.
Formal training for permanent staff - However, the Department has yet to
develop a comprehensive training program for its permanent processing workers.
During the last audit, it was reported that much of the training for processing staff
was done on the job by experienced employees, using whatever work procedures
generally were available. New employees are still trained by experienced coworkers
without the benefit of formal training materials. According to DOR's Training
Section administrator, funding for training has increased, but additional monies have
largely been devoted to revenue generating areas such as the Audit Section and
Collections.
The Department Has Taken Action
To Reduce Processing Errors
The Department has acted to reduce tax processing errors. DOR now compiles
information on common taxpayer errors and has improved its form design in an
effort to minimize processing errors. However, DOR could further reduce errors by
implementing quality control procedures to reduce staff errors.
( ) As a resul t, according t o the DOR budget o f f i c e r , temporary personnel expendi tures
have decreased from approximate1 y $ 783,300 i n f i s c a l year 1985- 86 to approximate1 y
$ 495,800 f o r f i scal year 1987- 88.
( 2 ) We projected i n 1985 t h a t DOR would need a t l e a s t 30 permanent p o s i t i o n s t o
e l iminate the excessive re1 iance on temporary workers. However, our c u r r e n t review
shows t h a t 24 p o s i t i o n s a l l b u t e l i m i n a t e DOR1s r e l i a n c e on temporary workers t o
meet r e g u l a r work l o a d s . Apparently, p r o d u c t i v i t y gains were even greater than we
a n t i c i p a t e d .
The 1985 audit reported that as a result of errors made by taxpayers and DOR
processing staff, an inordinate amount of personal and business tax returns were
rejected by DORIS processing system and sent to the Error Resolution groups for
correction, which delays processing. For example, 43 percent of all 1984 personal
income tax returns processed by DOR as of August 2, 1985, were routed to the Error
Resolution group. The previous audit reported that this situation was inefficient,
and that processing delays were the result of DOR's failure to identify the cause of
such errors and implement procedures to reduce these errors.
Taxpayer errors - In contrast to the last audit, in which we pointed out that that
DOR did not give enough consideration to recurring taxpayer errors, the
Department is now taking steps to minimize these kinds of errors. For example,
DORIS processing staff have compiled data on common taxpayer errors made on
individual income and sales tax returns. This information is relayed to taxpayers by
a representative of the DORIS Taxpayer Education Section during various speaking
engagements and through a new poster campaign initiated by the Department.
Moreover, DOR has made a significant effort to improve the design of its tax forms
and instructions. Our previous audit identified problems with the arrangement and
format of instructions for the individual income tax form, and reported that the
instructions could confuse taxpayers and lead to errors. DOR has since addressed
these problems. In contrast to the 1984 tax form and instructions, the 1986 form is
designed to facilitate ease of use. Improvements include more noticeable line
numbers and section headings, and a more readable page format.
Quality control procedures - DOR has implemented two important quality control
procedures. However, the Department has not systematically implemented quality
control procedures to monitor errors made by processing staff.
DOR has corrected one major source of internal processing errors. In response to a
recommendation made in our previous report, the remittance processing unit now
key verifies entries of social security numbers. An analysis of returns sent to
the Income Tax Error Resolution Section during our last review showed that 19
percent of all DOR caused processing errors were attributable to the Remittance
Processing Unit. The majority of these errors were incorrectly keyed social security
numbers. We concluded that key verification of social security numbers would
minimize the need to correct miskeyed entries. Now, the NCR computer system
will not process a social security entry unless it is keyed twice and the two entries
match. The supervisor of Remittance Processing says this new procedure reduced
these kinds of keying errors by 90 percent.
Additionally, DO R has established formal lines of com munication between
processing units that uncover errors and units that make them. For example,
according to Processing Section administrator, monthly meetings are held among
supervisors of the various processing units to discuss problems in processing. Weekly
meetings are held within the Income Tax Unit during the tax season.
DOR still does not systematically monitor employee accuracy. In our last report we
concluded that as a result, DOR is unable to take the corrective action necessary to
prevent returns from being routed to the Error Resolution Section. The current
situation is essentially the same. For example, according to processing staff and a
review of production reports, errors made by Document Staging, Data Entry, the
CorporateIW ithholding Unit and Remittance Processing are not systematically
monitored.
- DO R Has Upgraded Its Fiscal Monitoring
Of Outside Vendor Contracts
The 1985 audit reported that poor fiscal monitoring of outside vendors caused DOR
to be overcharged $ 423,000 by a data entry vendor, and $ 24,500 by a temporary
personnel services vendor. The audit recommended that D 0 R recover the
overcharges and institute better controls to guard against overcharges for copy
quality and keystrokes by data entry vendors.
Compensation for overcharges - The Department is being compensated for past
overcharges. The personnel services vendor agreed on October 31, 1985, to credit
the $ 24,500 owed to DOR to the Department's account. The data entry vendor
settled with DOR for $ 340,000 on January 31, 1986, and agreed to pay the
Department in the form of discounts for data processing services until the
settlement is paid in full.
Fiscal controls - DOR has also improved its administration of data entry vendor
contracts. For example, the Department now negotiates with data entry vendors in
deciding the quality of documents from which data will be input. Costs for data
entry differ depending on whether documents are judged good, fair or poor quality.
In the past, DOR allowed the vendors to unilaterally evaluate the quality of
documents, which increased the potential for overcharges.
Further, the Department has developed a computer program to monitor vendor
billings. Data entry billings are based on number of keystrokes. DO R's computer
program allows DOR to retabulate vendor keystrokes and ensure that i t is not being
overcharged.
Controls Over Receipts
Have Improved
In our last audit we reported that DOR could improve control over monies to reduce
the risk of theft or loss of revenue. Control procedures were weak in some areas
where revenue is received and processed. D 0 R has apparently strengthened
procedures; however, these procedures need to be formalized and periodically tested.
According to a recent review conducted by the Auditor General's Financial Audit
Division, receipt handling procedures used in the material areas of the Department
( Incoming Mail and Central Processing) are adequate. Additionally, tests of the
procedures indicate that DOR staff have generally complied with them. ( 1 )
( ' 1 Although the Financial Audit s t a f f found t h a t most cash hand1 i n g procedures were
adhered to by DOR s t a f f , they found t h a t some sales tax r e c e i p t s were not deposited
u n t i l a t l e a s t s i x days a f t e r r e c e i p t , even though deposits are t o be made w i t h i n 48
hours.
Further action is required to improve controls. For example, the procedures
described above still need to be written and formally adopted by the Department.
More importantly, although procedures may be adequate, DOR has no independent
internal audit group to periodically test staff compliance with procedures to ensure
that controls are working as intended. The Department included a funding request
for an internal audit group in fiscal year 1986- 87, but the request was turned down
by the Executive Budget Office and the Joint Legislative Budget Committee.
Although DOR has allocated money for one internal audit position, an audit team
with at least three positions would be more appropriate for DOR's needs. ( 1
RECOMMENDATIONS
1. The Department should continue working to develop a more formal and
comprehensive training program for its permanent processing staff. D 0 R's
0
Training Section needs to develop standard training procedures that prepare
processing staff to perform their duties.
2. DOR should develop a quality control system for monitoring errors made by
processing staff. Procedures should be developed to compile information on
staff errors for the overall purpose of curtailing the number of tax returns
routed to the Error Resolution groups.
3. The Department should develop written cash handling procedures and
establish an internal audit unit within the Director's office. The unit should
report directly to the Director of DOR. The unit's functions should include:
1) reviewing the adequacy of existing controls and procedures, and 2) testing
for compliance. The staff should have training and experience in accounting
and internal controls.
Moreover, the p r i o r r e p o r t recommended t h a t the i n t e r n a l a u d i t u n i t be placed w i t h i n
the D i r e c t o r ' s o f f i c e .
a
ARIZONA DEPARTMENT OF REVENUE
1700 WEST WASHINGTON PHOENIX, ARIZONA 85007
EVAN MECHAM
Governor September 2, 1987
Douglas R. Norton, CPA
Office of the Auditor General
State of Arizona
2700 North Central Avenue
Suite 700
Phoenix, Arizona 85004
Dear Mr. Norton:
C. " HOS" HOSKINS
Director
We have reviewed the draft report 87- 6 on the Department of Revenue and offer the
following response to it.
Generally, we are in agreement with the Findings and Recommendations. We- appreciate
the recognition given to the progress made to date, particularly as related to the
processing activity. We are proud of our success in improving the forms and the process-ing
of them and are pleased with the recognition of those accomplishments.
Specific responses to each finding and recommendation are as follows:
FINDING I
ADDITIONAL EFFOItT IS NEEDED IN THE AUDIT OPERATIONS.
A. Level of Audit Coverage is low. We agree with the finding and concur that the
results do not indicate any improvement in the amount of audit coverage. We had
delayed seeking additional staffing until we could improve the productivity of the
existing audit staff through the use of lap top computers and improved training and
audit controls. We also were concerned about increasing the audit staff before we
had the ability to support it adequately. As a consequence, it was felt that it was
more important to take the long- term approach and spend resources to improve both
the productivity and quality of the audit approach rather than the short- term
program to conduct more audits. The results over the next three years should d e t e r
mine if that was the correct decision.
In addition, it should be noted that, at this time, very few states even approach the
4% audit coverage level. A recent Colorado survey indicates that the average
coverage for western states business tax is well below 2%. The average state
corporate tax coverage was 1.4, as compared to our 1.7, and the average state sales
coverage was only 1.6, as compared to our 1.1%. Given the results of this recent
study, the validity of the 4% target needs to be re- evaluated.
B. Audit Selection Systems for Sales and Corporate Income Tax Programs still need
improvement. We agree we need to do more and are in the process of developing
improved processes for sales and corporate income tax.
OTHER LOCATIONS: 5555 N. 7th AVENUE, PHOENIX, AZ 85013 402 W. CONGRESS, TUCSON, AZ 85701
Douglas R. Norton, CPA
September 2, 1987
Page 2
We believe it should be recognized that Arizona's assessments per auditor are the
highest of all the western states. That would indicate that even though we believe
we can do better, the current audit selection programs are effective in that they
allow us to concentrate on the most productive audits.
We also must note that contrary to the report, the sales tax audit schedule was first
developed in 1985, was updated in mid- 1986, and is about to be updated again.
C. Improved Training. We agree that we have made substantial progress in develop-ment
of an auditor training program. The completion of that program is a corner-stone
of our plan for improved audit productivity.
D. DOR has taken steps to improve Audit Quality. We agree and will consider the
recommendations.
FINDING I1
THE DEPARTMENT HAS LARGELY ADDRESSED THE RECOMMENDATIONS MADE TO
IMPROVE PROCESSING.
A. Formal Training for Permanent Staff. The Department should continue to develop a
more formal and comprehensive training program for its processing staff. We agree.
Our training priorities remain with the Audit and Property Tax Programs. As soon
as they are completed, we plan to address these needs.
B. Quality Control Procedures. DOR needs to develop a quality control program for
monitoring errors made by the Processing staff. We agree additional effort is
required in this area.
C. Controls over Receipts have improved but need to be formalized. The Department
should develop written cash handling procedures and establish the Internal Audit
unit. We agree and are in the process of formalizing the procedures. The Internal
Audit Unit has been established and is in the process of being filled.
Again, we appreciate the fact that the report recognizes the progress made to date.
Sincerely,
AItIZONA DEPARTMENT OF REVENUE
C. " Hosn ~ oskins
Director

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AUDfWOR GENERAL
REPOR1 SUMMARY
September 1987 Report No. 87- 6
The Office of the Auditor General has conducted a performance audit of the Arizona Department
of Revenue ( DOR) in response to a July 26, 1985, resolution of the Joint Legislative Oversight
Committee. This performance audit was conducted as part of the Sunset Review set forth in
Arizona Revised Statutes 9941- 2351 through 41- 2379.
The purpose of this audit is to perform a follow- up review focusing on two previous performance
audit reports of the Department of Revenue. These reports, issued by the Auditor General in 1985,
are: Report 85- 5, Taxatiorr Division and Hearing Office; and Report 85- 9, Tax Processing
Function. This audit reports the extent of the Department's compliance with the recommendations
contained in the two previously issued reports.
The Department Has Made Some Changes In Audit Operations,
But Additional Efforts Are Needed
The Department of Revenue has not expanded audit coverage as recommended in the 1985
performance audit. Although the report estimated that increasing audit coverage of sales/ use tax
accounts would produce an estimated $ 18 million in additional assessments, coverage remains
un,-? anged, at approximately 1 percent for sales tax. DOR plans to increase audit coverage to 4
percent of the sales tax and corporate income tax account population, but only recently requested
the additional staff needed to increase coverage. DOR did not request additional auditors until
fiscal year 1988, and even though 15 new positions were authorized for fiscal year 1988, DOR
officials do not plan to f i l l them until at least February 1988 when its new building is expected to
be completed. Each month's delay in hiring the new auditors will result in the loss of an estimated
$ 600,000 in potential assessments.
Although some progress has been made, selection systems continue to need improvement and the
cyclical audit schedule of major sales taxpayers is outdated. Our analysis showed that 122 major
taxpayers were not scheduled for audit, while 65 scheduled audits were for taxpayers no longer on
the Department's list of large accounts. DOR staff attribute the discrepancies to changes in the
population of major taxpayers. However, the schedule has not been updated, as required by a
Department policy, since it was first prepared in early 1986. The Department has also been unable
to complete more than one- fifth of its 1985- 86 major taxpayer audits, and has not started or
completed more than 80 percent of its 1986- 87 audits of major taxpayers.
DOR has, however, improved some areas of its audit operations. A review of recent audit files
indicates that DOR has strengthened control of the audit process by improving documentation and
supervision. The Department has also established a training unit to develop a training program and
improve auditor capability to audit large, complex accounts; streamlined the audit protest process;
and eliminated the backlog of pending cases in the Hearing Office.
To improve audit coverage, DOR should continue its efforts to increase sales tax and corporate
audit staff. To resolve existing audit selection systems weaknesses, DOR should frequently review
and update its audit schedule of major sales tax accounts, and should develop an automated audit
history and selection system for corporate income tax accounts similar to that currently being
developed by the Sales Tax Audit unit.
The Department Of Revenue Has Largely Addressed
Recommendations Made To Improve Tax Processing
The Department has improved the effectiveness of its tax processing function by virtually
eliminating its use of long- term temporary workers. DOR accomplished this by converting 24
full- time positions occupied by temporary workers to permanent positions during fiscal years 1987
and 1988. Revenue officials report that the conversion has reduced turnover and increased
productivity as we had predicted.
DOR has also taken steps to reduce taxpayer errors that contribute to processing problems, by
increasing taxpayer education and improving tax form designs. Additionally, the Processing
Section has corrected one major source of DOR caused processing errors by key verifying social
security number entries.
DOR has strengthened its control over outside contractors. The 1985 audit reported that poor
fiscai monitoring aiiowed a data entry vendor and a personnel services vendor to overcharge the
Department by $ 447,500. Both vendors have agreed to repay the overcharges in the form of credits
and discounts. To prevent future overcharges, the Department now monitors billings through a
computer program that verifies data entry keystrokes.
Controls over monies have also improved. A recent audit conducted by the Financial Audit
Division of our office found receipt handling procedures to be adequate. However, the Department
still lacks an independent internal audit group to test adequacy of procedures and compliance with
them. DOR requested funding to create such a unit in fiscal year 1987- 88, but the request was
denied.
DOUGLAS R NORTON. CPA
AUDITOR GENERAL.
STATE OF ARIZONA
OFFICE OF THE
AUDITOR GENERAL
LINDA J. BLESSING, CPA
DEPUTY AUDITOR GENERAL
September 10, 1987
Members of the Arizona Legislature
The Honorable Evan Mecham, Governor
Mr. C. " Has" Hoskins, Director
Department of Revenue
Transmitted herewith is a report of the Auditor General, A Performance Audit
of the Department of Revenue. This report is in response to a July 26, 1985,
resolution of the Joint Legislative Oversight Committee.
The report is a follow up review of the Department's progress in implementing
recommendations made in previous audits of the Department's tax audit function
and its tax processing function. We found substantial improvement in both
areas. The Department has developed badly needed training for its auditors and
has improved audit supervision. However, audit coverage for sales/ use and
corporate income taxes has not changed significantly since our previous audit
and the Department needs to continue to improve its ability to identify and
select the largest, most productive accounts for audit.
In addition, the Department has improved tax processing. Tax forms have been
redesigned to better assist taxpayers in avoiding common errors. Use of
temporary employees to f i l l critical processing positions has been eliminated and
the Department has taken steps to reduce employee errors that contribute to
processing problems.
My staff and I will be pleased to discuss or clarify items in the report.
Respectfully submitted,
~ 0d'gl. hR~. Norton
Auditor General
Staff: William Thomson
Mark Fleming
Cindy Whitaker
Anthony Guarino
Kurt Schulte
2700 NORTH CENTRAL AVE. @ SUITE 700 @ PHOENIX, ARIZONA 85004 @ ( 602) 255- 4385
SUMMARY
The Office of the Auditor General has conducted a performance audit of the
Arizona Department of Revenue ( DO R) in response to a July 26, 1985, resolution of
the Joint Legislative Oversight Committee. This performance audit was conducted
as part of the Sunset Review set forth in Arizona Revised Statutes § § 41- 2351
through 41 - 2379.
The purpose of this audit is to perform a follow- up review focusing on two previous
performance audit reports of the Department of Revenue. These reports, issued by
the Auditor General in 1985, are: Report 85- 5, Taxation Division and Hearing
Office; and Report 85- 9, Tax Processing Function. This audit reports the extent of
the Department's compliance with the recommendations contained in the two
previously issued reports.
The Department Has Made Some Changes In Audit Operations,
But Additional Efforts Are Needed ( see pages 5- 13)
The Department of Revenue has not expanded audit coverage as recommended in
the 1985 performance audit. Although the report estimated that increasing audit
coverage of salesluse tax accounts would produce an estimated $ 18 million in
additional assessments, coverage remains unchanged, at approximately 1 percent for
sales tax. DOR plans to increase audit coverage to 4 percent of the sales tax and
corporate income tax account population, but only recently requested the additional
staff needed to increase coverage. DOR did not request additional auditors until
fiscal year 1988, and even though 15 new positions were authorized for fiscal year
1988, DOR officials do not plan to f i l l them until at least February 1988 when its
new building is expected to be completed. Each month's delay in hiring the new
auditors will result in the loss of an estimated $ 600,000 in potential assessments.
Although some progress has been made, selection systems continue to need
improvement and the cyclical audit schedule of major sales taxpayers is outdated.
Our analysis showed that 122 major taxpayers were not scheduled for audit, while 65
scheduled audits were for taxpayers no longer on the Department's list of large
accounts. DOR staff attribute the discrepancies to changes in the population of
major taxpayers. However, the schedule has not been updated, as required by a
Department policy, since it was first prepared in early 1986. The Department has
also been unable to complete more than one- fifth of its 1985- 86 major taxpayer
audits, and has not started or completed more than 80 percent of its 1986- 87 audits
of major taxpayers.
DOR has, however, improved some areas of its audit operations. A review of recent
audit files indicates that DOR has strengthened control of the audit process by
improving documentation and supervision. The Department has also established a
training unit to develop a training program and improve auditor capability to audit
large, complex accounts; streamlined the audit protest process; and eliminated the
backlog of pending cases in the Hearing Office.
To improve audit coverage, DOR should continue its efforts to increase sales tax
and corporate audit staff. To resolve existing audit selection systems weaknesses,
DOR should frequently review and update its audit schedule of major sales tax
accounts, and should develop an automated audit history and selection system for
corporate income tax accounts similar to that currently being developed by the
Sales Tax Audit unit.
The Department O f Revenue Has Largely Addressed
Recommendations Made To Improve Tax Processing ( see pages 15- 20)
The Department has improved the effectiveness of its tax processing function by
virtually eliminating its use of long- term temporary workers. D 0 R accomplished
this by converting 24 full- time positions occupied by temporary workers to
permanent positions during fiscal years 1987 and 1988. Revenue officials report
that the conversion has reduced turnover and increased productivity as we had
predicted.
DOR has also taken steps to reduce taxpayer errors that contribute to processing
problems, by increasing taxpayer education and improving tax form designs.
Additionally, the Processing Section has corrected one major source of D 0 R caused
processing errors by key verifying social security number entries.
DO R has strengthened its control over outside contractors. The 1985 audit reported
that poor fiscal monitoring allowed a data entry vendor and a personnel services
vendor to overcharge the Department by $ 447,500. Both vendors have agreed to
repay the overcharges in the form of credits and discounts. To prevent future
overcharges, the Department now monitors billings through a computer program
that verifies data entry keystrokes.
Controls over monies have also improved. A recent audit conducted by the
Financial Audit Division of our office found receipt handling procedures to be
adequate. However, the Department still lacks an independent internal audit group
to test adequacy of procedures and compliance with them. DOR requested funding
to create such a unit in fiscal year 1987- 88, but the request was denied.
TABLE OF CONTENTS
Page
INTRODUCTIONANDBACKGROUND. . . . . . . . . . . . . . . . . . . . 1
FINDING I : THE DEPARTMENT HAS MADE SOME CHANGES IN AUDIT
OPERATIONS, BUT ADDITIONAL EFFORTS ARE NEEDED . . . . . . . . . 5
Level Of Audit Coverage I s Low And
Unchanged Since Previous Report . . . . . . . . . . . . . . . . 5
Audit Selection Systems For Both Sales
Tax And Corporate Income Tax Need Further Improvement . . . . . 7
Sales Tax and Corporate Income Tax Audit Units
Have Taken Steps To Improve Audit Q u a l i t y . . . . . . . . . . . 11
DOR Has lmproved I t s A b i l i t y To Process
Protested Assessments . . . . . . . . . . . . . . . . . . . . . 12
Recommendations . . . . . . . . . . . . . . . . . . . . . . . . 13
FINDING II: THE DEPARTMENT OF REVENUE HAS LARGELY
ADDRESSED RECOMMENDATIONS MADE TO IMPROVE TAX
PROCESSING . . . . . . . . . . . . . . . . . . . . . . . . . . 15
DOR No Longer O v e r - u t i l i z e s Temporary Workers . . . . . . . . . 15
The Department Has Taken Action To Reduce
Processing E r r o r s . . . . . . . . . . . . . . . . . . . . . . . 16
DOR Has Upgraded I t s F i s c a l Monitoring
OfOutsideVendor C o n t r a c t s . . . . . . . . . . . . . . . . . . 18
Controls Over Receipts Have lmproved . . . . . . . . . . . . . 19
Recommendations . . . . . . . . . . . . . . . . . . . . . . . . 20
AGENCYRESPONSE . . . . . . . . . . . . . . . . . . . . . . . . . . 21
LIST OF TABLES
TABLE 1 - Audit Coverage Levels For Sales/ Use And
Corporate Income Tax For Fiscal Years
1984- 85 Through 1986- 87 . . . . . . . . . . . . . . . .
Page
. 6
INTRODUCTION AND BACKGROUND
The Office of the Auditor General has conducted a performance audit of the
Arizona Department of Revenue ( DOR). The audit was conducted in response to a
July 26, 1985, resolution of the Joint Legislative Oversight Committee as part of
the Sunset Review set forth in Arizona Revised Statutes § § 41- 2351 through
41 - 2379.
This report is a follow- up review which examines the steps taken by DOR to
implement recommendations made in two previous performance audit reports issued
by the Auditor General in 1985: Report 85- 5, an audit of DO R's tax audit function;
and Report 85- 9, an audit of the Department's tax processing function.
The Tax Audit Function
DORIS Tax Compliance Division, formerly the Taxation Division, contains two Tax
Audit Units: Sales/ Use Tax, and Income Tax. An officp: in Tucson also performs
sales/ use and income tax audits. These units conduct in- house audits of taxpayer
returns and field audits of taxpayer records to determine whether taxpayers are
accurately reporting and paying tax liabilities. Audits generate revenue when they
reveal that additional tax monies are owed to the State. DOR reported total audit
collections of $ 55.6 million in fiscal year 1984- 85, and $ 48.9 million in fiscal year
1985- 86.
However, several deficiencies were noted in a 1985 audit issued by the Auditor
General. It was reported that: 1) Audit coverage was low and DOR could collect up
to $ 18 million annually in additional revenue by increasing its sales tax audit effort;
2) DOR could increase revenue by improving audit selection systems; 3) DOR lacks
adequate controls to ensure the quality and integrity of audit assessments,
modifications and amendments; and 4) Protested assessments are not processed
efficiently, which increases the potential for loss of revenue.
The Tax Processing Function
Tax processing consists of several work procedures, and is performed within DOR's
Data Management Division. Tax returns are received in the Document Staging area,
where individual documents are briefly scanned to determine i f they look
processible. The returns are then sorted by tax type and fowarded to the Document
Processing areas, where they are batched with like documents and prepared for N C R
coding ( ' I or data entry. Once in the Data Entry area, document information is
entered into the computer system. If a tax document contains an error, caused by
either the taxpayer or DOR personnel, the computer rejects the form and the
document is sent to one of the Error Resolution areas for correction.
Our 1985 audit identified several problems with tax processing. The previous report
noted that the Department: 1) was excessively using temporary employees to f i l l
full- time positions; 2) could reduce processing errors and correct errors more
efficiently; 3) needed to improve its contract monitoring procedures; and 4) could
improve its control over receipts.
Scope Of Audit
This audit of the Department of Revenue's tax audit and processing functions is
limited to a follow- up of recommendations made in the two 1985 audits issued by
the Auditor General. It examines steps taken by DOR in the following areas.
0 The level of audit coverage for sales tax
0 Audit selection systems
0 Controls to ensure the quality and integrity of audit assessments, modifications
and amendments
( ' 1 NCR ( National Cash Register) machines are used by DOR to encode and s e r i a l i z e a l l
tax documents with money attached, and a l l checks accompanying these documents. Tax
documents received without money bypass NCR coding.
a The efficiency and timeliness of the protest process
a The utilization of temporary staff for tax processing
a Processing errors
a Contract monitoring
a Receipt handling controls
This audit was conducted in accordance with generally accepted governmental
auditing standards.
The Auditor General and staff express their appreciation to the Director and staff
of the Department of Revenue for their cooperation during the course of the audit.
FINDING I
THE DEPARTMENT HAS MADE SOME CHANGES I N AUDIT
OPERATIONS, BUT ADDITIONAL EFFORTS ARE NEEDED
The Department of Revenue ( DOR) Tax Compliance Division is taking steps to
comply with recommendations made by the Auditor General in 1985, but
improvements to date have been limited. The Department has not increased audit
coverage for sales/ use and corporate income taxes. Selection systems for each tax
type require additional improvement. However, the Department has improved audit
quality through stronger review and control, and has eliminated the Hearing Office's
backlog of protested audit assessments.
Level Of Audit Coverage Is Low,
And Unchanged Since Previous Report
Although DOR has developed a plan to increase audit coverage for both sales and
corporate income tax, current levels remain low. Current coverage is low compared
to DOR's goal of 4 percent for both sales/ use and corporate income tax. The
Department has recently received approval to hire additional auditors; however,
these positions w i l l n o t be f i l l e d immediately and are insufficient to meet coverage
and staffing goals.
Our prior audit report determined that DOR could generate up to $ 18 million in
additional revenue by performing more sales tax audits. To perform these audits, we
recommended that DOR increase its audit staff ( 24 auditors at an annual cost of
approximately $ 1 million). More audit staff would provide for a more favorable tax
base coverage and, therefore, increase audit assessments. We also recommended that
DOR study the feasibility of increasing corporate income tax audit staff.
Low coverage - Audit coverage levels have changed l i t t l e since fiscal year
1984- 85. DOR has adopted our recommendation of a 4 percent target level for both
While s t a f f s i z e has remained s t a t i c , the number o f sales accounts has grown
s i g n i f i c a n t l y . A t t h e t i m e o f o u r p r e v i o u s r e p o r t , there were approximate1 y 95,000
t o t a l sales tax accounts. As o f June 1987, the accounts had increased almost 27
percent t o 120,337.
salesluse tax and corporate income tax audits. However, this goal has not been
attained, and audit coverage for sales tax has, in fact, decreased. ' I' The
following table summarizes approximate audit coverage levels for the last three
fiscal years.
TABLE I
AUDIT COVERAGE LEVELS FOR SALES/ USE AND CORPORATE INCOME TAX
FOR FISCAL YEARS 1984- 85 THROUGH 1986- 87
Sour
Tax Type Fiscal Year
1984- 85 1985- 86 1986- 87
Sa I es/ Use 1 . l% 1.05% 1 . O%
Corporate Income 1.9 2.1 2.1 ' a'
( a ) This figure i s an estimate because complete data was not a v a i l a b l e .
: DOR budget request for f i s c a l year 1987- 88, and Auditor General
analysis based on information provided by the Assistant
Director of the Tax Compliance D i v i s i o n .
DOR management has determined that to reach its audit coverage goals, sizable
increases in audit staff will be necessary. The Department's fiscal year 1987- 88
budget request details a plan calling for 80 additional sales tax positions, based on a
three year phase- in period, while the corporate income tax unit plans to add 10
positions over two years. For fiscal year 1987- 88 DOR requested 36 audit positions
( 30 sales, six corporate). Only 15 ( 11 sales, four corporate) "' were approved. A
concerted effort to gain approval for these positions was not apparent
( ' ) These figures exclude four a u d i t o r positions approved f o r a u d i t selection and audit
review.
until the fiscal year 1987- 88 budget request. D 0 R did not request any audit positions
for fiscal year 1985- 86, in part because the fiscal year 1985- 86 request was prepared
before our report was issued. However, audit positions again were not requested in
fiscal year 1986- 87.
Hiring delayed - Although 15 new audit positions have been approved, the Director
of the Department does not intend to f i l l them until DOR conducts a staffing
analysis, and until the completion of the new DOR building, projected for February
1988. According to the Director, this delay is necessary due to insufficient space in
the existing office. The Department also plans to conduct an internal staffing
analysis to identify whether any existing staff can be transferred to f i l l the sales/ use
and corporate income tax audit positions. Furthermore, Department officials
indicated that before hiring more auditors, they want to complete development of the
Auditor training program and improve audit selection. However, since each auditor
generates approximately $ 40,000 in assessments per month, D 0 R stands to lose more
than $ 600,000 in assessments for each month the newly approved audit positions are
not filled.
Audit Selection Systems For Both Sales Tax
And Corporate lncome Tax Need Further Improvement
The audit selection systems used by the Sales Tax unit and the Corporate lncome Tax
unit still need improvement. Although the Sales Tax audit unit has placed all major
taxpayers that annually remit more that $ 500,000 in taxes on a cyclical audit
schedule, it still lacks a fully developed, automated selection system for the rest of
the population. Furthermore, the Corporate lncome Tax Audit unit has not been able
to place high dollar taxpayers on a cyclical schedule and still relies on a cumbersome
manual system for audit selection. DOR has improved auditor training to strengthen
its ability to conduct complex audits.
Our previous report noted that sales tax is the State's best tax revenue producer, and
that fewer than 2 percent of the sales tax accounts pay 70 percent of the total sales
taxes. A t the time of our last audit, a random sample of 300 of these large accounts
revealed that only 20 percent had been audited between January 1981 and August
1984. Our analysis showed that up to $ 3.6 million could be generated yearly i f DOR
audited more large sales tax accounts. Greater coverage of large corporate income
tax accounts was also recommended.
Sales Tax schedule - DOR acknowledges the need to review major taxpayers, and
has placed the 360 identified sales tax accounts with an annual tax remittance of
more than $ 500,000 on a schedule to ensure that each account is reviewed within the
four year statute of limitations. However, this schedule is not kept current and
timely completion of scheduled audits is not occurring.
Although a cyclical sales tax audit schedule has been developed, i t contains outdated
information. The sales tax audit unit developed its audit schedule for large accounts
using a DOR computer report of sales tax remittance data for several recent years.
To determine whether DOR has accurately identified and scheduled large accounts,
we compared accounts listed on the June 1987 computer report ( which contains
year- to- date remittances) to those accounts scheduled for audit during fiscal years
1988 through 1991. Our analysis revealed 122 of the 360 accounts listed on the report
that were not scheduled for audit, and 65 scheduled accounts that were not on the
report.
Sales tax audit selection staff attribute these discrepancies to changes in the
population of the major taxpayers, and the fact that the four year schedule has not
been updated since i t was first prepared in early 1986. DOR procedures call for an
annual review and update of the four year schedule. However, the procedure does not
indicate when the review should occur. As a result, the first review is tentatively
scheduled in December 1987, nearly two years after the four year schedule was
initially prepared.
In addition to having an outdated schedule, DOR is not able to review the accounts on
the schedule in a timely manner. We reviewed the audit schedules for fiscal years
1985- 86 and 1986- 87 and found that as of June 1987, nearly one- fifth of the audits
scheduled for 1985- 86 had not been completed, and more than 80 percent of the
audits scheduled for 1986- 87 had not been completed or started. This low rate of
completion raises concern, because only 41 audits of 31 accounts were scheduled for
1985- 86. and only 43 audits of 37 accounts were scheduled for 1986- 87.'') Since
DOR has not been able to complete these scheduled audits, problems in completing
the 90 accounts per year scheduled for audit for the next four fiscal years seem
imminent without additional audit staff.
Although DOR has a system to identify and schedule large sales tax accounts for
audit, i t does not have a fully developed selection system for the rest of the sales tax
population. Our previous report recommended that DOR continue work on the
M AASS ( Marginal Analysis Audit Selection System). M AASS, first obtained by DO R
in 1982, is designed to select accounts that have the highest assessment potential
within each industrial classification. DOR management has determined that the
problems encountered with M A ASS cannot be overcome. Consequently, the decision
was made to abandon this system and develop a similar, yet scaled- down model more
suitable for use within the Sales Tax audit unit. However, DOR does not expect this
system to be fully implemented and usable for another two years.
The new system, although not currently equipped for selecting accounts for audit
from the entire sales tax population, does show the progress the unit has made in
improving its audit selection system since our previous audit. The system, a
computerized audit history data base, contains pertinent account information on
audits and reviews completed since January 1983. The unit uses the data base for
scheduling audits and various other analyses. For example, the sales tax audit unit
uses the system to prepare the four year audit schedule of large sales tax accounts to
identify past lucrative audits and schedule follow- up audits of these accounts, and to
perform other evaluations of past audits.
Corporate selection system is still deficient - The corporate income tax audit unit
is not accurately identifying some high dollar accounts for audit, and has not placed
accounts on a cyclical audit schedule. This is due primarily to lack of current,
automated account data, as well as continued reliance on a manual selection process.
The number of scheduled audits i s g r e a t e r than the number of accounts because some
accounts were scheduled f o r both sales tax and use tax audits.
The 1987- 88 budget request states that all large corporate accounts are audited
every three years. Working with corporate audit staff, we attempted to verify this
assertion. A DOR report showing accounts reporting more than $ 500,000 yearly in
taxable income was compared to the unit's audit logbooks. Our analysis revealed that
approximately 53 percent of these large accounts had been audited since 1983.
Further analysis of a different report listing accounts with more than $ 500,000 in
annual tax remittance showed that only 58 percent of these largest taxpayers had
been audited since 1983.
Large accounts have not been identified in a timely manner, partially because the
present selection system is a manual, cumbersome process, which involves the yearly
examination of more than 50,000 returns. This process occupies the entire Phoenix
office corporate income tax audit staff for approximately one month.
Improved training - DOR has improved auditor training in response to a need
recognized in our previous report. Our previous report identified major deficiencies
in the level and amount of training given sales and corporate auditors. At that time,
both the sales tax and corporate income tax units had many auditors who had
received little or no training, and management commented that few staff were
capable of performing large, complex audits.
DOR recognized and took steps to correct this problem. Presently, three full- time
training coordinators are developing such a program to meet auditor training needs.
The training coordinators work with experienced auditors to develop technical
curriculum. DOR estimates show that sales and corporate income tax auditors have
devoted approximately 350 hours on course development from August, 1986 to
August, 1987. Audit staff also contributed 120 hours as instructors during formal
training sessions.
The manager feels that the program is only about one- third of what is needed, and
additional courses are being planned to train auditors in techniques for handling
different types of sales tax and corporate income tax audits. While many of the
courses currently being taught are general in nature, future courses being developed
will have a more technical emphasis. Further, a cooperative training program with
the IRS has been implemented.
Sales Tax And Corporate Income Tax Audit Units
Have Taken Steps To Improve Audit Quality
Our review of recent salesluse and corporate income tax audit files showed evidence
of improved documentation and review. Each unit has developed and formalized i t s
own review procedures. In addition, the Department is in the process of establishing
an independent audit review unit. However, policies for auditor rotation and
reporting of bribery have not yet been developed.
Our previous report identified inadequate controls for ensuring the integrity of audit
decisions and guarding against abuses. Significant changes were made to audit
assessments with l i t t l e or no review or documentation. In one case, this lack of
control resulted in DOR forgoing more than $ 1 million in tax assessments. In another
instance, an auditor was dismissed for failing to report a possible bribery attempt.
We recommended a centralized quality control unit as a means of reducing the
potential for abuse.
Formalized review - Both the SalesIUse Tax and Corporate Income audit units have
developed and implemented audit review procedures. ( " Each unit now requires
supervisory review and sign- off on all assessment documents, as well as separate
verification of all calculations. Our review of a small sample of files showed
adequate review in the sales tax audit files, but corporate income tax files showed
the need for more consistent evidence of review. ( 2 )
Review unit approved - Three of the newly approved audit positions are designated
for a centralized, independent quality control unit for all tax types to conduct an
objective technical review of completed audits and any resulting modifications or
amendments. This review group would help audit managers identify weaknesses in
documentation. Furthermore, the unit should provide better quality and more
consistent review because i t will be independent from the audit units, with review as
its only function.
( ' 1 Although our review was of Phoenix o f f i c e f i l e s o n l y , t h e A u d i t Administrator i n the
Tucson o f f i c e stated t h a t h i s a u d i t s t a f f use s i m i l a r review procedures.
( 2 ) DOR was unable t o l o c a t e one of the 20 sales tax f i l e s we requested f o r our review.
This f i l e contained a s i z a b l e assessment m o d i f i c a t i o n .
No rotation or bribery policies - Tax Compliance Division management has not
established formal policies for rotating auditors or reporting bribery attempts.
Management felt that high turnover in recent years precluded the need for such
policies. However, recent reclassification of the revenue auditor position has
reduced turnover, making rotation a necessity. Regardless, to improve control over
the audit function and prevent potential collusion between auditors and taxpayers,
DOR should adopt policies to l i m i t the number of consecutive audits of the same
taxpayer performed by an auditor and to require the reporting of bribery attempts.
DOR has improved its ability to respond to and process assessments that are
protested by taxpayers. The protest tracking system has been streamlined and
simplified through automation. The Audit Management Information System ( AMIS)
has automated all audit assessment records. The Hearing Office has improved the
timeliness of its process and has eliminated its backlog of cases.
A t the time of our previous report, the protest system relied on excessive manual
processing of documents, which resulted in errors and mishandling of cases. The
inefficiency was demonstrated by the 59 documents, five separate card files, and
eight logbooks used to process and track protests. Also, the Hearing Office had a
backlog of 63 pending cases that had been backlogged an average of 16 months.
AMlS was developed with the initial intention of automating the protest process.
According to Tax Compliance Division management, AMlS has eliminated the
reliance on the numerous and cumbersome card files and log books formerly used to
track protests.
More important, the Hearing Office now issues most decisions within 60 days.
According to the hearing officer, as of May 1987 only one case was pending more
than 60 days.
RECOMMENDATIONS
1. DOR should f i l l the newly approved auditor positions as soon as possible, renting
extra office space i f needed.
2. DOR should continue to request additional audit staff until i t is able to achieve a
coverage level of 4 percent for all salesluse and corporate income tax accounts.
3. DOR should ensure its sales/ use tax major account audit schedule is updated
annually for proper identification of these accounts.
4. DOR should make the resources available for the development of an automated
selection system and audit history database for the corporate income tax audit
unit.
5. DOR should continue to develop technical courses for its auditor training
program.
6. DOR should develop a policy mandating the rotation of auditors and reporting of
attempted bribery.
FINDING II
THE DEPARTMENT OF REVENUE HAS LARGELY
ADDRESSED RECOMMENDATIONS MADE TO
IMPROVE TAX PROCESSING
Although improvement is needed in some areas, the Department of Revenue ( DO R)
has largely addressed recommendations made in a prior performance audit to
improve its tax processing function. The Department no longer relies on temporary
employees, and has taken steps to reduce tax processing errors. DOR has upgraded
its contract monitoring procedures, and has made improvements in its receipt
handling controls.
In September 1985 the Auditor General issued a performance audit report on DOR's
tax processing function ( Report 85- 9). That report contained recom mendations on
the following topics: the use of temporary employees and staff training; tax
processing errors; fiscal monitoring of outside service contracts; and internal
controls over tax revenues. This follow- up review details the actions taken by the
Department to address those concerns raised in our previous report.
DOR No Longer Overutilizes Temporary Workers
DOR has improved its tax processing function by significantly reducing its reliance
on temporary workers. A comprehensive training program for permanent staff,
however, has yet to be developed.
A t the time of the previous audit, DOR used temporary personnel to an extent that
impaired the tax processing function. At least 37 and possibly as many as 60
temporary positions were continuous, year round positions. Temporary personnel
comprised between 40 and 52 percent of DOR's total processing staff. Our audit
work showed that temporary personnel are generally less productive than permanent
workers. As a result, the Department could actually save money by converting
temporary positions to permanent ones. In addition, temporary workers experienced
high turnover ( more than 200 percent annual turnover in some sections) and inhibited
DORIS ability to maintain a trained staff.
Decrease in temporary personnel - DORts reliance on temporary personnel has
significantly decreased since 1985. DOR converted 12 full- time positions occupied
by temporary workers to permanent positions in both fiscal years 1986- 87 and
1987- 88. These 24 positions were funded through transfers from the temporary
personnel services budget. ) Because of these actions, temporary personnel
will no longer be employed on a continuous, year round basis, but rather during peak
processing periods only. Moreover, DOR officials report that the decision to
convert temporary positions to permanent has stabilized staffing, as anticipated,
and resulted in productivity gains.
Formal training for permanent staff - However, the Department has yet to
develop a comprehensive training program for its permanent processing workers.
During the last audit, it was reported that much of the training for processing staff
was done on the job by experienced employees, using whatever work procedures
generally were available. New employees are still trained by experienced coworkers
without the benefit of formal training materials. According to DOR's Training
Section administrator, funding for training has increased, but additional monies have
largely been devoted to revenue generating areas such as the Audit Section and
Collections.
The Department Has Taken Action
To Reduce Processing Errors
The Department has acted to reduce tax processing errors. DOR now compiles
information on common taxpayer errors and has improved its form design in an
effort to minimize processing errors. However, DOR could further reduce errors by
implementing quality control procedures to reduce staff errors.
( ) As a resul t, according t o the DOR budget o f f i c e r , temporary personnel expendi tures
have decreased from approximate1 y $ 783,300 i n f i s c a l year 1985- 86 to approximate1 y
$ 495,800 f o r f i scal year 1987- 88.
( 2 ) We projected i n 1985 t h a t DOR would need a t l e a s t 30 permanent p o s i t i o n s t o
e l iminate the excessive re1 iance on temporary workers. However, our c u r r e n t review
shows t h a t 24 p o s i t i o n s a l l b u t e l i m i n a t e DOR1s r e l i a n c e on temporary workers t o
meet r e g u l a r work l o a d s . Apparently, p r o d u c t i v i t y gains were even greater than we
a n t i c i p a t e d .
The 1985 audit reported that as a result of errors made by taxpayers and DOR
processing staff, an inordinate amount of personal and business tax returns were
rejected by DORIS processing system and sent to the Error Resolution groups for
correction, which delays processing. For example, 43 percent of all 1984 personal
income tax returns processed by DOR as of August 2, 1985, were routed to the Error
Resolution group. The previous audit reported that this situation was inefficient,
and that processing delays were the result of DOR's failure to identify the cause of
such errors and implement procedures to reduce these errors.
Taxpayer errors - In contrast to the last audit, in which we pointed out that that
DOR did not give enough consideration to recurring taxpayer errors, the
Department is now taking steps to minimize these kinds of errors. For example,
DORIS processing staff have compiled data on common taxpayer errors made on
individual income and sales tax returns. This information is relayed to taxpayers by
a representative of the DORIS Taxpayer Education Section during various speaking
engagements and through a new poster campaign initiated by the Department.
Moreover, DOR has made a significant effort to improve the design of its tax forms
and instructions. Our previous audit identified problems with the arrangement and
format of instructions for the individual income tax form, and reported that the
instructions could confuse taxpayers and lead to errors. DOR has since addressed
these problems. In contrast to the 1984 tax form and instructions, the 1986 form is
designed to facilitate ease of use. Improvements include more noticeable line
numbers and section headings, and a more readable page format.
Quality control procedures - DOR has implemented two important quality control
procedures. However, the Department has not systematically implemented quality
control procedures to monitor errors made by processing staff.
DOR has corrected one major source of internal processing errors. In response to a
recommendation made in our previous report, the remittance processing unit now
key verifies entries of social security numbers. An analysis of returns sent to
the Income Tax Error Resolution Section during our last review showed that 19
percent of all DOR caused processing errors were attributable to the Remittance
Processing Unit. The majority of these errors were incorrectly keyed social security
numbers. We concluded that key verification of social security numbers would
minimize the need to correct miskeyed entries. Now, the NCR computer system
will not process a social security entry unless it is keyed twice and the two entries
match. The supervisor of Remittance Processing says this new procedure reduced
these kinds of keying errors by 90 percent.
Additionally, DO R has established formal lines of com munication between
processing units that uncover errors and units that make them. For example,
according to Processing Section administrator, monthly meetings are held among
supervisors of the various processing units to discuss problems in processing. Weekly
meetings are held within the Income Tax Unit during the tax season.
DOR still does not systematically monitor employee accuracy. In our last report we
concluded that as a result, DOR is unable to take the corrective action necessary to
prevent returns from being routed to the Error Resolution Section. The current
situation is essentially the same. For example, according to processing staff and a
review of production reports, errors made by Document Staging, Data Entry, the
CorporateIW ithholding Unit and Remittance Processing are not systematically
monitored.
- DO R Has Upgraded Its Fiscal Monitoring
Of Outside Vendor Contracts
The 1985 audit reported that poor fiscal monitoring of outside vendors caused DOR
to be overcharged $ 423,000 by a data entry vendor, and $ 24,500 by a temporary
personnel services vendor. The audit recommended that D 0 R recover the
overcharges and institute better controls to guard against overcharges for copy
quality and keystrokes by data entry vendors.
Compensation for overcharges - The Department is being compensated for past
overcharges. The personnel services vendor agreed on October 31, 1985, to credit
the $ 24,500 owed to DOR to the Department's account. The data entry vendor
settled with DOR for $ 340,000 on January 31, 1986, and agreed to pay the
Department in the form of discounts for data processing services until the
settlement is paid in full.
Fiscal controls - DOR has also improved its administration of data entry vendor
contracts. For example, the Department now negotiates with data entry vendors in
deciding the quality of documents from which data will be input. Costs for data
entry differ depending on whether documents are judged good, fair or poor quality.
In the past, DOR allowed the vendors to unilaterally evaluate the quality of
documents, which increased the potential for overcharges.
Further, the Department has developed a computer program to monitor vendor
billings. Data entry billings are based on number of keystrokes. DO R's computer
program allows DOR to retabulate vendor keystrokes and ensure that i t is not being
overcharged.
Controls Over Receipts
Have Improved
In our last audit we reported that DOR could improve control over monies to reduce
the risk of theft or loss of revenue. Control procedures were weak in some areas
where revenue is received and processed. D 0 R has apparently strengthened
procedures; however, these procedures need to be formalized and periodically tested.
According to a recent review conducted by the Auditor General's Financial Audit
Division, receipt handling procedures used in the material areas of the Department
( Incoming Mail and Central Processing) are adequate. Additionally, tests of the
procedures indicate that DOR staff have generally complied with them. ( 1 )
( ' 1 Although the Financial Audit s t a f f found t h a t most cash hand1 i n g procedures were
adhered to by DOR s t a f f , they found t h a t some sales tax r e c e i p t s were not deposited
u n t i l a t l e a s t s i x days a f t e r r e c e i p t , even though deposits are t o be made w i t h i n 48
hours.
Further action is required to improve controls. For example, the procedures
described above still need to be written and formally adopted by the Department.
More importantly, although procedures may be adequate, DOR has no independent
internal audit group to periodically test staff compliance with procedures to ensure
that controls are working as intended. The Department included a funding request
for an internal audit group in fiscal year 1986- 87, but the request was turned down
by the Executive Budget Office and the Joint Legislative Budget Committee.
Although DOR has allocated money for one internal audit position, an audit team
with at least three positions would be more appropriate for DOR's needs. ( 1
RECOMMENDATIONS
1. The Department should continue working to develop a more formal and
comprehensive training program for its permanent processing staff. D 0 R's
0
Training Section needs to develop standard training procedures that prepare
processing staff to perform their duties.
2. DOR should develop a quality control system for monitoring errors made by
processing staff. Procedures should be developed to compile information on
staff errors for the overall purpose of curtailing the number of tax returns
routed to the Error Resolution groups.
3. The Department should develop written cash handling procedures and
establish an internal audit unit within the Director's office. The unit should
report directly to the Director of DOR. The unit's functions should include:
1) reviewing the adequacy of existing controls and procedures, and 2) testing
for compliance. The staff should have training and experience in accounting
and internal controls.
Moreover, the p r i o r r e p o r t recommended t h a t the i n t e r n a l a u d i t u n i t be placed w i t h i n
the D i r e c t o r ' s o f f i c e .
a
ARIZONA DEPARTMENT OF REVENUE
1700 WEST WASHINGTON PHOENIX, ARIZONA 85007
EVAN MECHAM
Governor September 2, 1987
Douglas R. Norton, CPA
Office of the Auditor General
State of Arizona
2700 North Central Avenue
Suite 700
Phoenix, Arizona 85004
Dear Mr. Norton:
C. " HOS" HOSKINS
Director
We have reviewed the draft report 87- 6 on the Department of Revenue and offer the
following response to it.
Generally, we are in agreement with the Findings and Recommendations. We- appreciate
the recognition given to the progress made to date, particularly as related to the
processing activity. We are proud of our success in improving the forms and the process-ing
of them and are pleased with the recognition of those accomplishments.
Specific responses to each finding and recommendation are as follows:
FINDING I
ADDITIONAL EFFOItT IS NEEDED IN THE AUDIT OPERATIONS.
A. Level of Audit Coverage is low. We agree with the finding and concur that the
results do not indicate any improvement in the amount of audit coverage. We had
delayed seeking additional staffing until we could improve the productivity of the
existing audit staff through the use of lap top computers and improved training and
audit controls. We also were concerned about increasing the audit staff before we
had the ability to support it adequately. As a consequence, it was felt that it was
more important to take the long- term approach and spend resources to improve both
the productivity and quality of the audit approach rather than the short- term
program to conduct more audits. The results over the next three years should d e t e r
mine if that was the correct decision.
In addition, it should be noted that, at this time, very few states even approach the
4% audit coverage level. A recent Colorado survey indicates that the average
coverage for western states business tax is well below 2%. The average state
corporate tax coverage was 1.4, as compared to our 1.7, and the average state sales
coverage was only 1.6, as compared to our 1.1%. Given the results of this recent
study, the validity of the 4% target needs to be re- evaluated.
B. Audit Selection Systems for Sales and Corporate Income Tax Programs still need
improvement. We agree we need to do more and are in the process of developing
improved processes for sales and corporate income tax.
OTHER LOCATIONS: 5555 N. 7th AVENUE, PHOENIX, AZ 85013 402 W. CONGRESS, TUCSON, AZ 85701
Douglas R. Norton, CPA
September 2, 1987
Page 2
We believe it should be recognized that Arizona's assessments per auditor are the
highest of all the western states. That would indicate that even though we believe
we can do better, the current audit selection programs are effective in that they
allow us to concentrate on the most productive audits.
We also must note that contrary to the report, the sales tax audit schedule was first
developed in 1985, was updated in mid- 1986, and is about to be updated again.
C. Improved Training. We agree that we have made substantial progress in develop-ment
of an auditor training program. The completion of that program is a corner-stone
of our plan for improved audit productivity.
D. DOR has taken steps to improve Audit Quality. We agree and will consider the
recommendations.
FINDING I1
THE DEPARTMENT HAS LARGELY ADDRESSED THE RECOMMENDATIONS MADE TO
IMPROVE PROCESSING.
A. Formal Training for Permanent Staff. The Department should continue to develop a
more formal and comprehensive training program for its processing staff. We agree.
Our training priorities remain with the Audit and Property Tax Programs. As soon
as they are completed, we plan to address these needs.
B. Quality Control Procedures. DOR needs to develop a quality control program for
monitoring errors made by the Processing staff. We agree additional effort is
required in this area.
C. Controls over Receipts have improved but need to be formalized. The Department
should develop written cash handling procedures and establish the Internal Audit
unit. We agree and are in the process of formalizing the procedures. The Internal
Audit Unit has been established and is in the process of being filled.
Again, we appreciate the fact that the report recognizes the progress made to date.
Sincerely,
AItIZONA DEPARTMENT OF REVENUE
C. " Hosn ~ oskins
Director